Reserve Bank of Australia Bulletin
December 1996
The Task for Monetary Policy
Talk by the Governor, Mr I.J. Macfarlane, to
CEDA Annual General Meeting Dinner,
Melbourne, 28 November 1996.
Introduction
This is not the first time I have addressed
CEDA, but it is the first time as Governor. In
my new role, I am expected to say something
of significance on monetary policy and I hope
I will not let you down. On the other hand,
my comments are meant to apply to the
medium term, and there may be some
disappointment to those who are expecting
pointers on which way interest rates or the
exchange rate will move over the next month.
How Have We Gone So Far?
In line with my medium-term emphasis, my
starting point is to focus on the current
expansion which has been going on for more
than five years, ie from the middle of 1991.
Most other OECD countries have also been
undergoing some sort of expansion over this
five-year period, although some of them had
a later start. When we compare ourselves with
the OECD group during this period, we have
clearly done well (Table 1). Australia has
recorded a rate of inflation below the OECD
average, and yet this has not been at the cost
of feeble growth. Along with New Zealand,
Australia has grown twice as fast as the OECD
average. Of course, we could always have done
better but, over this period, most OECD
countries would prefer to have had our
economic performance than their own.
There is some evidence that we are now
getting recognised internationally for our
improved economic performance, but I am
not sure whether there is as much domestic
recognition of this change. We often hear of
popular dissatisfaction with the state of the
economy, summarised by such terms as
‘joyless recovery’ or ‘glum prosperity’. One
important reason for this is a feeling that there
has been too much economic change, and
hence an increased feeling of insecurity. The
two main factors here, of course, are
globalisation and technological change.
17
December 1996
The Task for Monetary Policy
Table 1: Major Economic Indicators
Average annual growth since June 1991
GDP
United States
Japan
Germany
France
United Kingdom
Italy
Canada
Belgium
Netherlands
Sweden
Switzerland
Spain
New Zealand
Core CPI
Unemployment
rate in latest month
2.6
1.2
1.3
1.1
2.0
1.0
2.0
1.3
2.0
0.7
-0.1
1.3
3.6
3.2
0.9
3.4
2.1
3.2
4.7
1.9
2.0
2.9
2.5
2.6
5.2
2.1
5.2
3.3
10.4
12.5
7.4
12.0
9.9
14.2
6.1
8.8
4.6
22.6
6.1
Australia
3.6
2.4
8.8
Average of above countries
1.9
2.8
7.5
The other reason for the disappointment in
the recovery is to be found in the third column
of Table 1, which shows the unemployment
rate. It came down quite quickly for a time,
from over 11 per cent, but after five years of
growth, it is disappointing that it has not fallen
further. It is little consolation to most people
that our productivity performance in this
upswing has been better than on previous
occasions, and better than in other countries
during this upswing.
The Challenge
What do we need to do to improve our
performance?
Clearly,
with
the
unemployment rate at 8.8 per cent and the
inflation rate at 2.4 per cent, we would all have
to agree that it is the former which is in the
greater need of improvement. While we all
agree on this point, there is less agreement on
what has to be done to bring about an
improvement.
18
Unfortunately, there is no panacea – the
answer will not be found in any single
breakthrough of policy or institutional reform.
Every policy and every practice should be
reviewed to see whether it is contributing to
or inhibiting the growth of employment. Are
we putting unnecessary obstacles in the path
of investment in new industries? Are our
industrial relations practices more concerned
with protecting the rights of people in jobs
than creating new jobs? Are our welfare and
retirement incomes policies encouraging
people to seek work or to avoid it? Are the
wage bargains that are being struck
encouraging firms to put on more labour or
to shed it? Is our education system turning
out people with skills that make them
employable?
Naturally, if we are to examine all these
policies and practices, it is only right that we
should look at monetary policy. As you know,
the focus of our monetary policy is an inflation
target, which is fully endorsed by the
Government. This essentially says that
monetary policy should be conducted so that,
in the medium run, inflation will average
Reserve Bank of Australia Bulletin
1
around 2 /2 per cent per annum. Some people
have interpreted an inflation target to mean
that monetary policy is only worried about
inflation, and that it is therefore anti-growth.
But this is not the case, as is demonstrated by
the results of the past five years – where growth
has been substantial while inflation has been
low. The other way of expressing an inflation
target is to say that monetary policy is set in a
way which lets the economy grow as fast as
possible without breaking the inflation
objective, but no faster.
The design of our inflation target gives us
the flexibility to put this into practice. Our
target recognises that there will still be a
business cycle and that, in the fastest growing
phase, there will be a tendency for inflation
to exceed our medium-term objective and, at
some other times, to fall below it. We do not
seek to keep within a narrow target band on a
period-by-period basis. It also recognises that,
in the event of a large shock, it is sensible to
bring inflation back on track over time, rather
than by some ‘cold turkey’ measures.
The settings of monetary policy in recent
years have been consistent with low inflation
on average and a good rate of economic
growth. Even so, some might argue for an
easier monetary policy – effectively saying
‘why not ease monetary policy as much as is
necessary to encourage faster growth, even if
it pushes up inflation?’ The problem with this
approach is that it does not work. Faster
growth may be achieved for a short period
and there may be some short-term fall in
unemployment, but in the medium term we
end up with higher inflation and higher
unemployment. This prescription has been
tried before in country after country and it
has failed. There is no long-term trade-off
between inflation and unemployment. You
cannot buy a better unemployment
performance by accepting a worse inflation
one. The unemployment rate would be no
lower over the business cycle if we average
5 per cent inflation than if we average
21/2 per cent inflation. Fortunately, this critical
point is becoming increasingly accepted.
Averaging a low inflation rate does not
inhibit growth or employment. What does the
December 1996
serious damage to growth and employment
is when inflation rises to unacceptable levels
and the economy has to be squeezed to reduce
it. All OECD countries have the experience
of three recessions in the past three decades
to remind them of this. It therefore follows
that the most useful thing monetary policy
can do in the long run for employment is to
encourage sustainable low inflation
expansions. I am not so optimistic to think
that we can do away with the business cycle
completely, but with good management, we
should be able to delay and reduce the severity
of any future contractionary phase by ensuring
that inflation remains low.
As well as explaining our monetary policy
framework, we have to ask ourselves whether
policy could be conducted better within that
framework. We have to make sure that we do
not become too risk-averse and impose too
restrictive a speed limit. This would be the
case, for example, if we failed to take into
account factors which were holding prices
down, while at the same time opening up
possibilities for faster growth. There certainly
are many such factors – the reduction in tariffs,
for example, and other aspects of globalisation
in goods and capital markets; domestic factors
which have increased the degree of
competition in some industries; and
technological changes which are producing
bigger productivity improvements than in
earlier periods. We recognise that these factors
have played a role in our improved inflation
performance over recent years and we have
taken them into account in setting policy. They
are making the job of conducting monetary
policy easier, but they are not causing us to
‘over-achieve’ on inflation.
There are also a number of residual attitudes
which are making it more difficult, some of
which will be covered in the next section.
Adjusting to Low Inflation
The theme of my first speech as Deputy
Governor in May 1992 was that low inflation
19
December 1996
The Task for Monetary Policy
was here to stay – it was not just a temporary
cyclical phenomenon. I am still preaching this
sermon and, with five years of low inflation
under our belt, plus a world that is in much
the same position, a lot of people have come
to share the view and have acted on it. This
has led to some very useful outcomes.
Businesses have become more concerned
with productivity, cost control and efficiency.
Planning horizons and contracts have
lengthened. The best example of this is the
rebirth of fixed interest mortgages where the
interest rate is locked in for up to five years.
Wage bargains also have longer time horizons,
with two and three-year contracts not
uncommon.
As well as providing more certainty in
enabling people to plan, there have also been
cost savings. As the rest of the world has come
to see Australia as a low inflation country, we
are able to borrow on international capital
markets more cheaply. Ten years ago, yields
on Australian dollar bonds were 6 percentage
points higher than yields on US dollar bonds;
the gap has now narrowed to less than
1 percentage point (Graph 1). These gains
have not been confined to business or
government borrowers; mortgage interest
rates are as low as they have been for a
generation.
Our new found credibility in international
capital markets has other policy implications.
The popularity of Australian dollar
investments (along with New Zealand dollar,
Graph 1
Ten-Year Bond Differential Between
Australia and US
%
%
7
7
6
6
5
5
Differential
4
4
3
3
2
2
1
1
0
0
1986
20
1988
1990
1992
1994
1996
Canadian dollar and pound sterling) has lifted
our exchange rate appreciably at a time of
subdued commodity prices. The principal
source of this inflow of funds has been the
Japanese household investor who has sought
alternatives to the near-zero returns on offer
in Japan. While the higher currency has been
helpful from an inflation perspective, it has
put pressure on our export industries and
those competing with imports. The pressure
will be particularly felt in those industries
which have let their domestic cost structure
move up too fast.
There are a number of areas where the
adjustment to low inflation is not proceeding
as smoothly as we would like. The one I will
talk about tonight is wage bargaining. I
suppose this is not surprising, as over the past
five years or so we have been moving from a
centralised wage fixing system to an
increasingly decentralised one. While this is
essential to provide the flexibility for Australia
to survive in an increasingly competitive
world, there clearly have been some
transitional difficulties. The difficulties first
became apparent in the second half of 1994
when some enterprise bargains produced
outcomes for wage increases which were much
higher than likely inflation and overall
productivity gains. There have been other
instances since, and we have spent a lot of
time trying to analyse what is happening.
It should also be pointed out that there
appear to have been a lot of very sensible
enterprise bargains and, in addition, there is
a large part of the workforce that has received
only small wage increases because they have
not been part of the enterprise bargaining
process. As a result, average wages across the
whole economy have not grown at an excessive
rate over the past 12 months; they have, in
fact, slowed down from growth of over
5 per cent in mid 1995 to about 33/4 per cent
at present. This was, of course, a very
important reason why it was possible to ease
monetary policy twice in the last six months.
The tensions in the wage enterprise
bargaining area remain, however, and cloud
the outlook for inflation, but more particularly
for unemployment. This is best illustrated by
Reserve Bank of Australia Bulletin
developments in the metals industry. Over the
past two years, enterprise bargains in this
sector have yielded an average increase in
wages of over 5 per cent per annum. This looks
high relative to a general inflation rate of
2.5 per cent, and even higher compared with
the increase in prices in the metals industry,
which have been only around 1/2 per cent per
annum. The latter figure suggests that the
metals industry as a whole is very competitive
and open, and metals manufacturers have
virtually no pricing power. They are caught
in a wage-price squeeze with potentially
debilitating effects – profits in the metals
industry were 30 per cent lower in the first
three quarters of 1996 than a year earlier.
Note that in this sector the high wage
increases have not contributed, so far at least,
to increased inflation in Australia at all, as is
evident by the 1/2 per cent per annum increase
in output prices. The effects, instead, have
shown up as flat output and falling
employment. In those parts of Australian
industry which are open to international forces
or where domestic competition is intense,
excessive wage bargains are less of a worry
because of their inflationary impact than
because of the increased unemployment they
cause.
This is not the whole of the story. In other
sectors where the economy is still relatively
closed, excessive wage increases will be
potentially inflationary. This makes it difficult
for monetary policy. We do not know the
extent to which excessively high wage
settlements will spread to other parts of the
economy, particularly if executive pay sets a
bad example, as seems to be the case at
present. We also do not know the extent to
which wages are pushing up unemployment
or being passed into higher prices to
consumers. To some extent an increase in
wage dispersion might be seen as part of the
normal adjustment to a less centralised labour
market. But, to the extent that the leading
increases serve as pace-setters for the economy
as a whole, they will have an adverse impact
on macroeconomic performance.
I would like to end by saying a few words
about the ‘Living Wage’ claim currently before
December 1996
the Industrial Relations Commission. The
individual wage outcomes which the labour
market is delivering will, in general, take
account of inflation, productivity growth in
the enterprise or industry in question, and the
bargaining position of workers. We would not,
as a result, expect to see all wages increasing
at the same rate, and dispersion of wages
would probably increase. This is an
implication of the decision by the previous and
present Governments to move to a
decentralised wage fixing system after so many
decades of a centralised one. We have an
interest in this subject because, in the present
environment, it is difficult to distinguish wage
dispersion from the outlook for average wage
growth. In one sense, a wider dispersion can
be helpful for the smooth running of the
economy in that it may well create more
opportunities for people with differing skills
and experience to find a job. But a significantly
wider dispersion may set up tensions and
pressures for ‘catch up’, then ‘leap frogging’
which can be the driving force of continuing
inflation. So finding the right balance in the
dispersion of wages is important.
Under present institutional arrangements,
the Industrial Relations Commission has a
role in deciding whether, and by how much,
it should boost wages for those not covered
by enterprise agreements. In doing so, it will
have to balance its equity objectives against
the impact of these actions on efficiency.
Boosting wages at the lower end of the
distribution would have two effects – it would
raise the overall wage increase, and compress
wage dispersion. Neither effect will be helpful
for employment growth, especially for those
with low skills or little work experience. Some
of the least skilled will be priced out of a job,
although the size of this effect is difficult to
determine.
The community may well, however, wish to
see some support provided for the weakest
bargaining groups. While there are other policy
instruments for achieving equity objectives,
such alternative channels also have their
efficiency costs. So intervention to nudge up
minimum wages is probably a reasonable
expression of community preferences. As an
21
The Task for Monetary Policy
example of this, the ‘safety net’ pursued in
recent years has been compatible with low
inflation. Continuation of such ‘safety net’
adjustments, as proposed by the Government,
seems sensible to us. But if the interventions
are more wide-ranging, the outcome will be
slower employment growth – either because
individual employers respond to the
price/wage squeeze facing them, or because
the Bank is forced to respond to emerging
inflationary pressures by raising interest rates.
Such an economy-wide macro response may
seem unsatisfactory, particularly if the wages
claims are seeking to re-establish longstanding
wage relativities. But the alternative – to allow
these incipient inflationary pressures to be
transformed into higher actual inflation – is
hardly beneficial to the industrially weak. It
would simply erode the apparent gains made
by workers at the bargaining table and in the
Commission, and set the scene for further
rounds of wage increases. With the painful
experience of reducing inflation still fresh in
our minds, we see nothing to be gained – and
much to be lost – in accommodating
inflationary pressures.
In time, the various players in the economy
will adjust to the low inflation environment
and the decentralised wage fixing system, and
I feel confident that we will find, on balance,
the changes are worthwhile. But new systems
require new skills, and there is still a lot of
22
December 1996
learning to be done. One requirement is that
senior management will have to play a much
bigger role in wage bargaining than in the past.
In the new world, wages will vary from firm
to firm; competitive advantage will not just
be a function of which firm has the best
marketing, production or finance team, but
which one is best at enterprise bargaining. In
the new world, wage claims will also bear a
closer resemblance to what used to be termed
‘capacity to pay’. Wage claims – even ambit
claims – of 7 1 / 2 per cent per annum in
industries with flat output and pricing
prospects will not be treated seriously. Unions
which pursue them will increasingly face the
questioning of members who recognise that
higher wages cost jobs – perhaps their own.
All this has concentrated on the linkage from
wages to prices. But history tells us that this
is a two-way relationship, with wages also
responding to inflation, rather than causing
it. I want to register with you that I understand
that linkage, and understand that if workers
make wage deals on the basis of low inflation,
then we need to deliver that. The best
contribution that monetary policy can make
to safeguarding workers’ real wages from
erosion by inflation is to ensure that inflation
stays low.You will sense, from what I have said
today, that we take this commitment very
seriously.